troduction of a minimum funding requirement 1997, replaced since 2005 by a risk-based levy
pension protection scheme, with an accompanying need to notify the regulator of certain events such
as changes in credit rating, changes of ownership and breaches of loan covenants. Such regulatory
impositions have inevitably increased the cost and reduced the attractiveness of DB plans to UK em-
ployers, regardless of accounting requirements. Regulatory changes regarding pension provision
have occurred in other countries, some of which are similar in scope and effect as those that have
taken place in the UK and some of which are dif- ferent. These factors need to be borne in mind
when considering studies about the impact of pen- sion accounting rules on pension provision in dif-
ferent countries. We refer to these, as appropriate, when discussing the evidence in subsequent sec-
tions.
At an aggregate level, DC plans undoubtedly are cheaper for employers than DB plans. For exam-
ple, the employer’s contribution in 2005 as a pro- portion of the employee’s salary averaged 16 for
DB schemes and only 6.3 for DC schemes Government Actuary’s Department, 2006: 94.
However, care needs to be taken in interpreting these figures. Pension arrangements are but one
part of an employment package. Employees with DB pensions might have very different bargaining
power than those with DC pensions, making sim- ple comparisons between the two forms of pension
provision misleading. If the sole objective of a firm in moving from a DB plan to a DC one is to
reduce payroll costs, this can be done in a variety of ways that need not entail terminating their DB
plans.
3
The simplest way would be to require the employees to make greater contributions, or to re-
duce pension benefits e.g. by cutting the accrual rate, or by cutting some other component of the
pay package.
4
The major drawback of DB schemes nowadays is that they expose the employer to
volatile demands for cash injections.
5
Another drawback of DB schemes that has been raised in
various quarters is that recent changes in pension accounting rules have also increased the volatility
of pension expense reported in the profit and loss statement.
With this general picture in mind, we turn next to considering the question of how pension ac-
counting has changed and the likely consequences.
3. The accounting changes and the reactions to them
Until comparatively recently, UK companies had a free hand in how they accounted for their DB
schemes. No real distinction was drawn between DB and DC plans, both being accounted for essen-
tially on a pay-as-you-go contributions basis. This changed with the introduction of SSAP 24 ASC,
1988, except that the calculation of DB pension cost continued to be based on actuarial valuation
methods that had underpinned the pension funding decisions. These methods allowed considerable
discretion in the calculation of pension asset val- ues and liabilities. Assets were traditionally valued
by actuaries using a variety of prospective-yield methods designed to iron out variations in market
prices. Liabilities were measured using a rate that reflected the fund’s asset allocation strategy – the
more it invested in higher-yielding and hence more risky assets, the higher the rate used to dis-
count the liabilities. In essence, SSAP 24 allowed for an accrual method of determining pension ex-
pense that smoothed out pension surpluses and deficits. In contrast, by requiring pension assets to
be measured at market value and pension liabilities to be discounted using the yield on AA-rated cor-
porate bonds, FRS 17 ASB, 2000 exposed to public gaze the extent to which the employer had
surpluses or deficits in its DB plans. While compa- nies were required as from 2001 to make disclo-
sures in the notes to their financial statements, full implementation of FRS 17 was postponed until
2005 so as not to burden them with a change be- fore the switch to International Financial
Reporting Standards IFRS required in that year. Since that date, UK firms have had to recognise
their pension plan surpluses or deficits as an asset or liability on their balance sheets and to record
any actuarial gains and losses in the statement of total recognised gains and losses.
What was the expected effect of these changes when they were introduced? To answer this ques-
tion, we provide a brief summary below of the analysis we have carried out of relevant aspects of
the responses received by the ASB to three sets of proposals it has issued at different times on pen-
sion accounting. This evidence has to be treated with caution as individuals and organisations make
Vol. 39 No. 3 2009 International Accounting Policy Forum. 257
3
Insights into why DB plans have become more costly than DC plans can be gleaned by considering the effect of an an-
nounced increase in life expectancy of employees and pen- sioners. In the case of DC plans, the cost would be borne by
the employees and pensioners unless the employer increases its contributions. In the case of DB plans, because the accrual
rate of pension benefits is usually defined by a pre-specified formula, the cost would be borne by the employer, unless ei-
ther the accrual rate or any contributions required of the em- ployees were changed.
4
It is worth noting in this regard that employees enrolled in DB schemes, on average, do make larger proportionate contri-
butions than do those in DC schemes – 4.4 versus 2.7 Government Actuary’s Department, 2006: 94.
5
For example, the Pensions Regulator 2007: 70 certified £9bn of special contributions to reduce deficits in 2007. In the
US, aggregate employer contributions increased from an aver- age of about 30bn per year between 1980 and 2000 to 45bn
in 2001 and to 100bn in 2002 and 2003 Buessing and Soto, 2006.
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such submissions with a view to influencing the development of standards and as such the sample
inevitably suffers from selection bias. The ASB received 137 letters in response to
FRED 20 ASB, 1999, its proposed replacement for SSAP 24. This response rate is far greater than
is usual for exposure drafts, reflecting the far- reaching nature of the proposed changes notably,
to switch from an actuarial to a market basis for valuing assets and to include pension surpluses
and deficits on the balance sheet. Many respon- dents expressed the fear that the proposals might
lead to the demise of DB plans. This concern was widely shared across groups, including specialists
in the pension’s field e.g. Institute and Faculty of Actuaries, National Association of Pension Funds,
Pensions Management Institute, and various actu- arial consulting firms and accountants e.g.
Institute of Chartered Accountants of Scotland and Midlands Group of Finance Directors. The pri-
mary reason cited was that the proposals would in- crease the volatility of pension costs that would be
reported in the profit and loss statement and result in large fluctuations in pension surpluses and
deficits included on the balance sheet. Some re- spondents speculated that companies might alter
their pension investment strategies to counter this increased volatility. Others thought that the prac-
tice of enhancing scheme benefits especially in respect of past service might be jeopardised if
companies were required to recognise the costs immediately rather than spreading them out over a
longer period.
Some respondents explained why they thought these changes to financial reporting would have
such major effects on corporate behaviour. In some cases the underlying unarticulated fear ap-
pears to be that the volatility FRED 20 would in- troduce into financial statements would have
detrimental effects on share prices. This assumes, of course, that the market was not already taking
into account companies’ pension exposures. There is a considerable body of US research indicating
that share prices reflect firms’ off-balance sheet pension surpluses and deficits and that the mar-
ket’s assessment of equity risk does reflect the risk of the firm’s pension plans Landsman, 1986; Jin
et al., 2006. On the other hand, Franzoni and Marin 2006 present evidence of the market sig-
nificantly over-valuing firms with severely under- funded pension plans, suggesting that while
investors took some account of pension exposures afforded by SFAS 87 FASB, 1985a disclosures,
they did not fully incorporate into prices the nega- tive impact of a large pension deficit on future
earnings and cash flows. It is hard to oppose changes to accounting requirements if they are
likely to lead to better informed investors, even if pension provision is affected as a result. Indeed,
some respondents expressed exactly this senti- ment.
Some respondents were concerned that the changes might constrain firms’ actions and this
might lead them to abandon their DB schemes. For example, the Confederation of British Industry
voiced the concern that the inclusion of pension deficits on the balance sheet might limit their abil-
ity to pay dividends. This is a situation where ac- counting numbers serve to constrain managerial
actions, in addition to providing information for investors. It could be argued that, if it is the case
that changes in pension accounting would restrict the payment of dividends in an unintended and
harmful manner, the best solution would be to amend the provisions of the company law govern-
ing distributions.
The response to the ASB’s proposed amendment to FRS 17 and associated proposed disclosures
ASB, 2006 was much more muted.
6
Of the 44 letters received, only one raised any questions
about the likely effect on pension provision. Legal General expressed the view that any require-
ment to disclose the buyout cost of DB schemes would ‘… inevitably have a negative impact on
market perceptions of the employing companies, leading to a further reduction in the appeal of de-
fined benefit schemes for employers’ on the ground that the buyout cost would typically exceed
the FRS 17 liability. Though they outline why they think the buyout cost is misleading, they treat it as
self-evident that its disclosure would confuse in- vestors.
As part of the long-term review of pension ac- counting being carried out by the International
Accounting Standards Board IASB and the Financial Accounting Standards Board FASB the
ASB in conjunction with the European Financial Reporting Advisory Group EFRAG issued a new
discussion paper on the subject ASB, 2008 which attracted 100 comment letters. Two sugges-
tions in the paper particularly concerned corre- spondents:
• Replacement of the AA-rated corporate bond yield with a risk-free rate to value pension lia-
bilities. Respondents worried that the resultant increase in reported pension liabilities would in-
crease the incidence of deficits and this might drive firms to invest in government bonds with
attendant increases in costs of pension provi- sion.
• Use of the actual rate of return in place of the ex- pected rate of return in the measurement of the
return on plan assets in the profit and loss state-
258 ACCOUNTING AND BUSINESS RESEARCH
6
The proposed amendments were that FRS 17 disclosure requirements should be replaced with those of IAS 19 and that
the buyout value of scheme liabilities should also be disclosed.
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ment. The resultant increase in earnings volatili- ty would encourage firms to close their DB
plans. A number of respondents commented negatively
on the recommendation in the discussion paper that normal consolidation principles be applied
such that pension assets and liabilities should be included in the employer’s balance sheet on a
‘gross’ rather than ‘net’ basis. It has been estimat- ed by Shivdasani and Stefanescu 2008 that lever-
age ratios for firms with pension plans would be about 35 higher in the US if pension assets and
liabilities are treated in this manner.
Our reading of the 281 comment letters submit- ted to the ASB on pension accounting suggests
there is widespread concern that the changes in pension accounting will cause firms to make sub-
optimal pension provision decisions driven by short-term reporting considerations. We return to
this issue in Section 7.
Concerns over changes in pension accounting requirements have not been restricted to the UK.
Of particular importance has been the debate sur- rounding the move in the US from SFAS 87
FASB, 1985a to SFAS 158 FASB, 2006 which led to the elimination of the ‘corridor method’ and
the recognition of the funded status of the pension plan on the balance sheet. The corridor method
provides a means of smoothing the impact of actu- arial gains and losses on reported income.
7
Under SFAS 158, such gains and losses are recognised
immediately in other comprehensive income. As SFAS 158 also requires the recognition of the net
difference between pension assets and liabilities on the balance sheet, pension accounting has be-
come embroiled in the debate over whether fair value accounting has contributed towards the cred-
it crunch Moody’s Investor Service, 2008; Plantin et al., 2008.
4. The impact of accounting on DB pension provision
